Monday, May 12, 2014

In praise of bottom-feeders

A fascinating quote in today's Wall Street Journal: Warren Buffett to Tim Geithner just after the Bear Sterns bailout:

"I was sort of hoping you wouldn't do it, because then everything would have crashed and I would have been first in line to buy."

Buffett continued,

"It would have been terrible for the country, but I would've made a lot more money"

Amen on number one. A's fire sale is B's buying opportunity. In the end, a lot of finance depends on flexible long-only money to come in and take risks when others are selling.

Absolutely wrong on number 2, Mr. Buffett. There is no more patriotic act an American sitting on a few billion dollars can perform, than to show up at a fire sale with a fat checkbook and a pen.

It would certainly have given courage to other wealthy investors, endowments, hedge funds, and sovereign wealth funds.

A bottom-feeders' frenzy might also have shown to the likes of Mr. Geithner the limits of constantly repeated stories of "no buyers," limitless "fire sales," "liquidity spirals;" the belief that that only highly-leveraged and panicky intermediaries set asset prices, so government must always bail out all creditors.

A good Bear Stearns failure might well have saved us from a bad Lehman failure.

When Buffett said, "It would have been terrible for the country, but I would've made a lot more money," he may have meant the crash would have been terrible for the country--not his stepping in and making money.

Michael and Ben: Yes, I think I got the same interpretation -- and I'm suggesting that because he would have stepped in, it would not have been bad for the country. In fact it might have been great for the country by galvanizing the private bottom feeders.

I like the point made by Joseph Stiglitz in his critique of HFT. Asking how much trading there should be, he notes that the social optimum allows traders to benefit from their information, especially when it is costly to produce. Perhaps you are making the same point.

But I have little appreciation for bottom feeders if they are merely benefitting from financial frictions and their side effects, such as momentum and fire sales. We should try to eliminate those frictions, starting with the missing market for the savings of uninformed investors. In the current system, it is difficult to make naked bets on GDP, which leads people to save via housing or investment funds, many of which try to synthesize the market portfolio - because the asset that savers really need is not available. If it was available, and highly liquid, there would be fewer liquidity spirals - perhaps none. If we had a market for uninformed savers, then more of the trading in individual stocks would be based on information about those companies. Things might be even better if shares in the aggregate economy are used as the numeraire for stock prices.

"A good Bear Stearns failure might well have saved us from a bad Lehman failure."

How do you figure? Lehman was going to fail no matter what happened to Bear Stearns. Lehman plowed a lot of leverage into soon to be worthless MBS. Then they sold the MBS portfolio on a REPO deal so they could buy even more MBS. When the REPO contract was due, Lehman had no way to make the payment. How could any policy vis-a-vis Bear Stearns have saved Lehman?

By this logic you must think the Lehman failure was a good thing, right? It seems to me to be a good thing that losses were allocated to where they should have been (equity, debt holders and not the tax-payer) but the knock on effects the the broader financial system (including raising costs of finance for solvent businesses) were net/net bad.

The cost/benefit analysis is not so straightforward for finance as it is for other industries. I don't see much in the academic literature to help so a lot of the time this sort of argument comes down to priors. Yours are clearly laissez-faire but I don't see much here to convince me you are right..

Why do you have to pretend that financing is any different from other goods? The "bad" side of the equilibrium adjustment of rice prices to increased demand is that existing buyers have to pay higher prices for rice. No one complains about that (well except socialist morons, but assuming you aren't one)

It was the change in the cost and availability of mortgage financing (almost overnight, tirggered by a run on the shadow banking system) that re-priced housing markets, led to a collapse in their output and broader consumer confidence.

Debt is different than other goods. Its nominal price is protected by a legal system (bankruptcy law). The price of other goods is generally not legally protected unless the government invokes cost controls or supports (also known as socialism).

The World tried this in 1929, setting in motion the events leading to WWII and more than 100 million deaths. The argument made is not even wrong (Pauli); worse it is myopic. Who knows what countries and what destabilization would have followed.

It's a serious stretch to atttribute WW2 purely or largely to 1929's aftermath. Germany's disastrous hyerinflation rpeadtes it, for isntance. Not to mention the VersaillesTreaty, fall-out of the Bolshevik revolution, etc. The liquidationist approach that Prof. Cochrane advocates is not politically realistic, I think, at present, but from a suppyl-side economics standpoint, it worked pretty adequately in the "long 19th century".

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.

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About Me and This Blog

This is a blog of news, views, and commentary, from a humorous free-market point of view. After one too many rants at the dinner table, my kids called me "the grumpy economist," and hence this blog and its title.
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!